The Story of Two People and Their Path to Financial Independence

You can see the Introduction and summary of what we are talking about here. You should also read the disclaimer here:

***Disclaimer ***

This is written for educational purposes. I am writing to explain my understanding of these principles. Please, do your own research and talk to a licensed professional before putting this into practice. The intent of this article is to aid in understanding, point you in the right direction, and to allow you to ask a licensed professional questions that may pertain to your individual situation. If you see something wrong, please let me know with documentation, so that I can adjust and get all the information as correct as possible.

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Ok, the lawyering is out of the way… on to the fun stuff.

Basic Introduction To Legal Business Entities

There are several reasons why you would want to set up a small business. Some examples include setting up a side hustle, creating a separate entity to own rental properties or trying to make the next Google or Apple. What ever your reason, there are 3 main ways to structure your business according to the legal system:

Sole Proprietor – This is very easy to set up. Any income you make comes straight through to your 1040 income. You can write your expenses off against this income. You’ll also owe self employment tax on any profit from this. But, the key here is that you personally are responsible for any liabilities.

Limited Liability Company – Again the income passes directly to the ownership and you’ll owe self employment tax. Unlike, the SP there is a legal difference between you and the entity, so the entity carries the liability. Hence the name … Limited Liability. One down side to this is: it’s a little difficult to divide up if you need to sell off shares for investing, fund raising, etc. It can happen, but it’s not as clean.

Corporation – This is what you see traded on the NYSE. It’s all the big names that you know and love. There are two versions of a Corporation: a C-Corp and an S-Corp. A C-Corp which is what you know as a member of the S&P 500. It pays a separate corporate tax on the income of the corporation itself, then the owners pay tax again once they are paid. An S-Corp – which like the SP and LLC passes it’s income to the owners and it goes on the owners’ 1040.

While setting up a legal entity is a huge PITA (Pain In The Ass), it is worth having legal separation in the off chance you get sued. They can only go after the assets of the company. Your personal assets are not considered part of the company assets in LLC’s or Corporations.

In all these scenarios, you are subject to a variety of taxes. Most of these should be fairly familiar to you, mainly your standard income tax. In each of these situations, other than the C-Corp, the profit from the company becomes income to the owner and is therefore taxed as part of your personal AGI. You’ll owe self employment tax based on the company income that is passed through to you. You also may or may not be required to contribute quarterly estimated tax payments (think withholding, but since you don’t have a steady pay check, you don’t have the withholding).

You’ll need to go through a bunch of hoops to get one of these things set up. I’m not going to go into all that here, but if you’re interested you can ask… or you can go here to start looking at all the legal processes, etc.

Then you have your take home left at $35,820. ($60,000 – $15,000 – $9,180 = $35,820)

Simply by opening a business and pushing all your expenses against it you’ve upped your take home pay by about 30% ( $35,820 – $27,350 = $8,470 –> $8,470/$27,350 ~ 30%).

Wow! That makes quite a difference.

Got it? Ok, let’s look at more real numbers:

There is some nuance to every single situation. The graduated tax rates also add some complexity. Let’s look at our 100% deductible $40,000 expenses against different income levels:

W2 vs SE Tax Brackets & Take Home difference

If you have a small business, you can actually take home quite a bit more money. It really narrows down during the transition away from the FICA taxes. You’ll also notice that your tax rates increase faster through a corporation, because of the self-employment tax.

What else you can see is that as you can push more of your expenses against the company, the more advantageous it gets. Look at the difference it can make given our default numbers:

Take Home Pay Difference by % Deductible Expenses

If you don’t have any expenses to put against your company, there’s no advantage. It’s actually more expensive since you have that self-employment tax. But, you can find something, your company can pay your phone bill, cable/internet bill, gas, travel, even part of your rent!

This can get really interesting if your company takes a loss (has more expenses than income). Because, that loss will also pass-through to your personal income and actually reduce the total AGI of your household.

Great, so what do we have?

We have an S-Corp for a couple of different reasons. The main one being: Due to the nature of the business, we were not allowed by CA state law to be an LLC.

While it’s a little more complicated than an LLC, being an S-Corp has some benefits. It’s easier to take on investors if we need to in the future and we can get around some of the pay roll taxes**. That and, we are required to have a nice dinner on the company every year as a board meeting :).

Until next time…

This is a super simple example of how getting your revenue through a business entity can save you quite a bit on your taxes. That’s all fine and good. But my guess is that my fellow FIRE folks are more interested in how you can use this in conjunction with retirement accounts to accelerate your savings even more.

Tune in next time where I talk about the various small business retirement plans.

** In the process of writing this the Government decided to pass a huge tax reform bill. This whole mess doesn’t really apply here since this is assumed to be paid out as wages. We’ll explore pass-through income (draws) in a later post. Also, LLC’s can file as S-Corps for tax purposes.**

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19 Comments

Excellent work, as always. I will re-read this when I’m awake and can process the information efficiently! Can’t wait for the next part in the series!Gwen @ Fiery Millennials recently posted…200k at 27

And I thought NC was expensive at $200/year. You know you can form this in another state right? Delaware, MD, LV are mentioned as being some of the best states for an LLC. The nonprofit I worked for in NY was incorporated in DE.

Many people say doing an LLC is easy but I think if we form one, I at least want to talk with a lawyer or an accountant. Since we have the Talking Trash vlog and want to sell an e-book, I want to make sure everything is under the LLC umbrella.

Also, yes you can roll everything under one. There’s nothing that says you can’t diversify your business. We run everything through ours, Mrs Wow’s business, any tech consulting I do and this blog actually. Its more a matter of book keeping.

This is great man… it’s nice to see the hypothetical numbers with the math laid out. Looking forward to your take on the pass-through income and implications with the new law.Accidental FIRE recently posted…Stop Being So Cheap

The process is pretty easy. Yeah there are some fees but if you don’t need it to be super bullet proof you can just go through legal zoom. I went through an attorney with ours because of the nature of the business.

Thanks so much for this! One of the most helpful articles I’ve read in a while!

My wife is a pediatric OT and recently started her own business! She has a sole proprietorship and took out insurance. She pays under $100 annually for a $4 million insurance policy. Do you think that is an appropriate strategy? I saw you mentioned: “the key here is that you personally are responsible for any liabilities.”

So, I’m not sure about the insurance policy, and quite frankly insurance is my arch enemy.

I’m also not an attorney, so I’d definitely run it by one of those in your state.

If I were to guess, should you get sued and the settlement goes above the limit of the policy, or the insurance finds a way to not pay (which I wouldn’t put past them) you are personally liable for that overage given a sole proprietorship.

With an LLC or a Corp, only the company is liable, you are not personally, so your personal assets are protected. Granted you maintain your corporate duties, board meetings and the like.

So, I guess it’s a matter of risk tolerance and the complexity of setting up the entity in your state. There are also considerable advantages for taxes on a corporation/llc versus a sole proprietor.

I would imagine given this you can’t just run around with no insurance commiting malpractice everywhere going “I’m a company, can’t touch me”. I’m guessing you have to be a reasonable person, or “not a shithead” as we like to say around here.